Volatility, Intermediaries and Exchange Rates
56 Pages Posted: 20 Nov 2016 Last revised: 22 Dec 2019
Date Written: December 20, 2019
We study exchange rate determination through financial intermediaries. We propose a model in which the participants in the FX market are intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter leverage constraints. Therefore, intermediaries require higher returns to hold foreign assets and the foreign currency is expected to appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from covered interest rate parity. The model generates new implications for exchange rates and capital flows consistent with the data.
Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Risk, Value-at-Risk
JEL Classification: G15, G20, F31
Suggested Citation: Suggested Citation